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3 Reasons You're Being Set Up to Fail

According to a Prince and Associates survey conducted during the height of the financial crisis, four out of five high-net-worth investors were planning to take money away from their financial advisors. Surprised? I'm not.

The odds are stacked against us
Especially if we have money invested with a mutual fund conglomerate we saw advertised on TV. And, as you're about to see, the cumulative damage to your long-term wealth can be devastating.

Today, I'll reveal three reasons why I believe we have been set up to fail. Plus, why I'm convinced the stakes have never been higher, and why the mantra, "You can't make money buying and holding stocks anymore" is nonsense.

If you agree that what I say makes sense, I'll offer an alternative you can consider. So let's start with the No. 1 reason most U.S. investors fail ...

1. Thinking inside the box
You probably know the Morningstar-style box -- that nine-box grid that shows whether your mutual fund invests in large-cap, mid-cap, or small-cap stocks. And whether the focus is on growth or value -- or some blend of the two. OK, fine. Except for one thing.

The more the style box was used to classify fund managers, the more they seemed to be pigeonholing themselves (and us) into an investment style. To see how much this might be costing us, consider the path chosen by renegade investor Peter Lynch at Fidelity Magellan Fund. For 13 years, his investors earned 29.2% per year.

Lynch did it by thinking outside the style box. Sometimes he'd stock up on growth, other times value.

If he were running Magellan today, he'd as likely buy unloved mega-cap Microsoft (Nasdaq: MSFT  ) -- trading for less than 10 times free cash flow -- as under-the-radar Chinese small cap Yongye International (Nasdaq: YONG  ) -- despite the fact it's barely been public a year -- or as entertainment giant Activision Blizzard (Nasdaq: ATVI  ) with its lofty P/E ratio of 43. (More on these three companies in just a minute.)

In short, Lynch was a financial mercenary who refused to be hemmed in by some "box." That's how he doubled his Magellan shareholders' money in less than three years, then did it again and again for 13 years. That kind of courage is hard to find today, which brings us to the second reason we've been set up to fail.

2. Following the herd
Why anyone would imagine that "following the herd" could make them money in this market is beyond me. But I can tell you (in six words) why professional money managers do it: Picking stocks is a lonely business.

If you're all about keeping your job, it's safer to buy what others buy. Don't believe me? Guess which companies are found in many of the top five holdings of the most widely held mutual funds.

How about AT&T (NYSE: T  ) , Apple (Nasdaq: AAPL  ) , and Oracle (Nasdaq: ORCL  ) ?

I know, shocker! What's worse, these companies also rank in the top 15 for market cap of the S&P 500 index. Meaning their growth potential is quite limited, and these funds will basically only mirror the performance of the index, with such large allocations to these popular stocks.

Of course, it's pretty much the same with any "large-cap growth" fund your advisor will get you into. You don't need a financial advisor to tell you that owning the same stocks as everybody else is no way to get ahead. Or that you can never expect to beat the market by owning the market. Right?

Here's proof ...
What I've just described is called closet indexing. It's rampant on Wall Street, and investors pay billions in "management" fees each year for the favor. Yet of the 7,600 or so who invested money for U.S. investors in 2009, you can expect 78% to 95% to fail to beat the market, according to Yale University's David Swenson.

I knew it was bad, but 78% to 95%? That surprised even me. But I got that figure from John Bogle's latest book, Enough, so I believe it. And at the risk of being labeled a Boglehead, I'll cite him again, because no one speaks more eloquently on the third and most important reason investors fail.

3. Getting killed by costs
I don't just mean the fund management fees we've discussed, but investment turnover, too. Not to mention capital gains taxes and trading commissions.

In his book, Bogle shows how, assuming market returns of 8.5% per year, you can expect these intermediation costs to eat up to 80% of your profits over the course of a 40-year investing career. Again, it sounds unlikely, but Bogle runs the numbers in the book; it's worth checking out.

But here's the point
Whether Bogle's 80% figure is high or low, we can agree: Coupled with the constraints placed on fund managers by the style box, and the understandable temptation to follow the herd, investors have a high hurdle to overcome -- especially if they rely on mutual funds.

Add to that a new, bear-market-inspired belief among certain financial advisors that they can -- and should -- help you time the market, and you can see why I say the stakes have never been higher. I mean, come on. You could argue that these market-timing converts might have come in handy in October 2007.

But we sure didn't need them "rotating" us out of stocks at the bottom, even though it meant racking up transaction costs and missing out on the ensuing huge rally. Of course, that's exactly what happened to many U.S. investors this year. Some may stay out of stocks for years -- and that's a crime.

Now your solution ...
Listen: None of this is rocket science. Neither is my solution -- namely, that you start managing some of your own investments, and thus avoid the three reasons investors fail. If you're a purist like John Bogle, buy a low-cost index fund and be done with it.

Bogle doesn't believe we can beat the market with individual stocks. But I do. In fact, I've seen it.

Remember those three grab-bag stocks I mentioned earlier -- Microsoft, Yongye International, and Activision Blizzard? Those were hand-selected by top analysts on our Million Dollar Portfolio team. They recommend (and buy -- with The Motley Fool's money) stocks of all shapes, sizes, industries and countries to members of the service, with remarkable results.

Since the team began in October 2007 (as the financial meltdown began, mind you), they've outperformed the market by nearly 8.5%.

It certainly helps that the team of analysts is made up of very different investors with distinct styles. Short of finding another Peter Lynch, they may offer your best bet to break from the style box that hems in most professional investors and steer clear of the herd mentality on Wall Street.

And even if Bogle's right and you can't beat the market picking stocks, you can avoid the third, most deadly threat to your long-term wealth: crippling financial intermediation costs. That's because we're about to open up the doors to our Million Dollar Portfolio service for the last time in 2010. And the fee to get access to the team's exclusive stock recommendations and analysis will set you back a mere fraction of what you'd get with a full-service financial advisor.

And if, like most investors, you continue to follow the portfolio's moves, it won't set you back 80% of your rightful profits. Most important, you'll get the advice and support you need to stay invested, even when those who should know better cut and run. To learn more about this special opportunity to join Million Dollar Portfolio, click here.

This article was originally published October 8, 2009. It has been updated.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Adam J. Wiederman owns no shares of the companies mentioned above. Microsoft is a Motley Fool Inside Value pick. Apple and Activision Blizzard are Motley Fool Stock Advisor recommendations. Yongye International is a Motley Fool Global Gains selection. Motley Fool Options has recommended a synthetic long position on Activision Blizzard and a diagonal call position on Microsoft. The Fool owns shares of Activision Blizzard, Apple, Microsoft, Oracle, and Yongye International. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 19, 2010, at 4:00 PM, TMFLifeIsGood wrote:

    <i>Meaning their growth potential is quite limited</i>

    <i>This article was originally published October 8, 2009</i>

    AAPL closed on October 8, 2009 at $189.27.

    AAPL closed yesterday at $318.00

    This puts AAPL up 68% since this article was originally written. With a record quarter, the iPhone hitting stride in China, and the iPad supply constraints resolved, I'm not sure how you can justify saying the AAPL's growth potential is quite limited.


  • Report this Comment On October 19, 2010, at 4:19 PM, XMFDonauschwaben wrote:


    The original article published on Oct. 8, 2009 didn't have Apple mentioned. That was added to the version I updated today.



  • Report this Comment On October 19, 2010, at 6:21 PM, johwell wrote:

    While Bogle makes some good points, I think the advice to manage your own money is not for everyone. I know highly successful, high-income earners who have destroyed their own financial future because they don't/can't pay attention the way proper money management requires. More than timing the market, I'm referring to reading the prospectuses of various investment vehicles.

    For example, there are exchange traded funds, but then there are funds that are called exchange traded that are quite different. Someone has to do that research. My Dad was invested in an Oppenheimer fund that lost 80% in 2008. It was supposed to be a conservative bond fund. After the carnage, I came to realize that it invested in real estate swaps and was stuck in them until June 2009. Guess who's to blame? My Dad. Since then he's interviewed a bunch of financial advisors, found one he liked, and though the returns haven't been stellar compared with the market, my Dad feels better knowing someone is watching out for his benefit.

    Financial Advisors/Brokers get a bad rap--and maybe most of it is deserved. But there are good ones out there. The idea that we can do everything ourselves is supremely arrogant and usually wrong. Financial Advisors (at least mine) urged me to get back into the market in 2009. I waited until June. I'd have probably 30% greater gains if I got in when he first told me to. But as my advisor tells me, you wouldn't operate on yourself, why would you try to pick your own investments.

    In fact, it occurs to me as I post on this site, that even the readers of this site who champion self-styled investing are relying on the Fool to help them narrow the myriad of choices that exists in the various markets. So, with all due respect to Mssrs Bogle and Swenson, I believe that there is a good financial advisor out there for everyone and he or she can take their fee. I, for one, gladly pay it.

  • Report this Comment On October 19, 2010, at 6:54 PM, Anysimplefool wrote:

    If you can't or won't do the work to manage your own money properly, then by all means either buy a mutual fund or hire a financial advisor. Far too many people never get past the idea that investing is a form of gambling. If you never learn how to invest then it is merely gambling.


  • Report this Comment On October 20, 2010, at 2:49 AM, ChrisFs wrote:

    It was a good post until the end when you seemed to contradict your entire post by recommending that investors sign up with a service that would cost them the same fees and the same risk of closet indexing etc.

  • Report this Comment On October 20, 2010, at 8:42 AM, jpbash19 wrote:

    "Activision Blizzard (Nasdaq: ATVI) with its lofty P/E ratio of 43"

    I'm not sure if you are just using Yahoo! Finance data without really using fundamental numbers, but Activision-Blizzard has a P/E ratio nowhere near 43. TTM EPS would have a P/E between 11 and 12. Forward P/E would be even less. I like the article on a thematic basis very much, though. I fully agree that independent thought is being smothered by analyst recommendations, herd mentality and a gross over dependence in indexing.

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